Exchange Traded Funds (ETFs) are among the most unwise investments that any investor can make. These are basically mutual funds that are open for purchase or redemption during the trading day, unlike traditional open-ended mutual funds, which can only be bought or redeemed based on their values at the close of daily trading. ETFs, which are designed to track various market indexes, offer the seductive allure of low management fees and diversification, which has enabled the largest asset managers to peddle roughly $3 trillion worth of these to naive investors who are willing to take a package of lousy companies in order to get exposure to some great ones.
The recent volatility in the stock market has been turbo-charged (admittedly, in both directions) by the flows in and out of ETFs. For example, 200 individual ETFs own shares of Facebook. When Facebook got into difficulty recently due to concerns about the public dissemination, for political purposes, of its members' private information, widespread fears that its business model (getting your data for free and selling it to advertisers) was in trouble, the stock began to sell off precipitously. As Facebook's individually traded shares plummeted from their peak of $195, the forced liquidation by ETFs, needing to maintain valuation parity, accelerated the rate of price decline, which in turn brought forth more selling. This same effect has also caused shares of Tesla, Amazon, Nvidia, and Google, among others, to sell off sharply. Each of these has had its own individual fundamental issues that triggered selling. Because these are among investors' favorites, the impact on the overall market has been brutal, to say the least. The fact that we are approaching the end of the first quarter has also magnified the selling pressure, since there is inevitably some portfolio window dressing by mutual funds.
This February/March period is analogous in many ways to October 1987, when the averages declined more than 20% over two days, despite the fact that the economy was in sound shape and corporate profits were in a steady uptrend. At this writing, the S&P 500 Stock Index is barely above 2,600, which leaves it with a very reasonable forward 2018 price/earnings multiple of about 16, substantially above the 4.6% yield on BBB bonds.
Our client portfolios have not been immune from this selling pressure. Most of the stocks we currently hold still have unrealized appreciation, in many cases substantial, but to be sure, we have given back a measure of our profits, more than the 2.6% year-to-date decline in the S&P 500.
However, liquidity in the financial system is still plentiful, despite the small boost in the Federal Funds rate, the gradual shrinking of the Fed's balance sheet, a narrowing in the 10/2 yield spread to 50 basis points, and a widening of the Libor/OIS spread. The economy is accelerating. The corporate profit uptrend is very much intact. We are maintaining the vast majority of our positions, as each is meeting profit objectives. The Index itself has essentially retraced its "Benchmark Low" of February 9th, and appears to be in the process of forming a "Confirmation Low." Once the headline risks fade, the overall market should resume its advance at a pace that, at best, will parallel earnings gains, because some P/E compression is likely in a rising interest rate environment. Needless to say, we are alert to any fundamental changes which would cause us to rethink our position.
